"One of the biggest public-housing projects in history will help determine whether China can remake its real-estate sector fast enough to prevent its economy from flaming out.

"China is in the midst of a crash program to build 36 million subsidized apartments by the end of 2015—enough units to house the entire population of Germany. The goal is twofold: to head off social unrest by ensuring decent places to live for low-wage workers, but also to cushion an expected fall in high-end construction—the result of policies to tame property speculation—by ramping up construction at the low end: so-called social housing.

"Social housing is the No. 1 priority when it comes to support economic growth, ensure social stability and bring down average housing prices, as far as the government is concerned," said UBS analysts Tao Wang and Harrison Hu in a recent note."

Just as the luxury housing market begins to tank (prices have fallen dramatically in key markets such as Shanghai), government policy is pumping lots of money into so-called "social housing." Worried that the lower classes are squeezed out of the housing market, government policy is encouraging the state-owned banks to invest in lower cost, lower margin real estate developments. The government fears social unrest because of the boom in luxury housing units and the incentives for local governments, which own the land, to target land sales toward these higher margin sales. (Perhaps not so ironically, the luxury housing market itself is a product of policy encouraging real estate development through state-owned banks.)

At first glance, China appears to be following the conventional Asian model of using public housing to fill in the gaps in the private market. Both Hong Kong and Singapore followed this model. But, the housing market is more than just building new housing units. The right units need to be built at the right price and at the right time. With the steep subsidies going into social housing, it's unclear whether the central government will bail out the state-owned banks when the investments fail to generate the anticipated returns. And, with the Chinese economy showing signs of slowing, government housing policy may in fact make matters worse. As the Journal reports:

"But critics argue that Beijing is mismanaging the social-housing effort. While the central government set the housing goal, it has largely left the implementation and financing to local governments, which get much of their revenue by selling land to developers for luxury apartments, not low-profit housing.

"There is widespread suspicion that Chinese municipalities are inflating the number of apartments they are building, or relabeling projects already under construction as social housing. In November, for instance, the Ministry of Housing said work on foundations was sufficient to qualify as "housing starts," prompting derision that it was counting holes in the ground. Of 30 developers surveyed by Standard Chartered Bank, 21 said that less than 30% of the social housing being built was actually new construction.

"The social-housing project may also lead to bad loans a few year's down the road. "The lion's share of the funding comes from the [state-owned] banking system," said He Fan, an economist at the Chinese Academy of Social Sciences. While apartment sales may turn a profit, rental properties probably won't, which "will be a heavy burden for banks," he said. He compares the program to "highways in the desert," which he claims some local governments have built to meet highway-construction targets."

A better approach would be to reduce barriors to the market-provision of low and moderate income housing and let the high-income market depreciate to find the market-clearing price. While this wouldn't avoid the downturn altogether, more transparency in market prices would helpd rationalize investment in the real-estate market.

Importantly, not all markets in China will suffer the same fate. China is a vast nation with individual provinces having their own internal economic dynamic. Thus, what's true in Shanghai might not be true in Chongqing. For an interesting take on this, from the perspective of the so-caled "ghost cities," read Wendell Cox's articles over at newgeography.com.